ETFs Made Easy: Understanding Spreads

This is an extremely common pattern—the initial bids and asks here are almost 30 cents wide. That said, five minutes into the day, those spreads collapsed to about 6 cents wide, where they remain all day long. This is one of the reasons we always say, “don’t trade the open.” ETFs need their morning coffee just like everyone else.

The second question you need to ask is whether those spreads are “fair.”

The way you’d normally check that is by looking at the intraday net asset value (NAV)—a near-real-time calculation disseminated by the exchange on which the ETF is listed—to see how it maps to where the ETF is actually trading. For example, here’s how the actual trades of KBWP matched up against iNAV yesterday:

Source: FactSet Research Systems

Finding Fair Value

You can see that while KBWP (the blue line) only traded a handful of times, the underlying stocks that drive the intraday NAV (the yellow line) changed values all day. For a thinly traded ETF like KBWP, this looks “pretty good.”

To know with absolute certainty, you’d have to calculate a “bid fair value” and an “ask fair value” for every one of the underlying holdings, then compare that with the bid and ask of the ETF. In fact, that’s exactly what market makers do while they’re trying to figure out when to leap in and arbitrage out any price discrepancies.

But as an ETF investor, you can mostly ignore that level of detail and simply look at spreads and INAV to see whether they’re all in the ballpark.

One final note: It can be helpful to glance at how an ETF normally trades. When you go to the Screener at ETF.com, or an individual fund page, you’ll see an “average spread” calculation. KBWP’s, for instance, is 18 cents wide, or 42 basis points. Calculating that is trickier than it looks.

In many places, you’ll find just take the last spread of the day—at the close—and average that out over some number of days. The problem is that closing spreads are just plain dumb. Most investors should never be trading at the close at 4 p.m. Eastern Time on the nose and on the open market.

We look at every millisecond of each day and calculate a time-weighted average spread. So if the spread is 20 cents wide all day, but blasts open to 25 cents right at the close, that 25 cents won’t matter much in the calculation. We also discard outliers outside a standard-deviation band each day to make sure we’re really representing the real-world spread an investor is experiencing.

We then take the median of 45 trading days of those time-weighted average spreads.

That may sound complicated, and in practice, it’s a lot of math. But luckily all those computations can give you a very good understanding of what “normal” is for an ETF. And in this case, “normal” for KBWP is 18 cents wide.

Dave Nadig is VP and director of exchange-traded funds at Factset Research Systems. At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.